Three moving average trading strategies

This article provides three moving average trading strategies, for use in either trending markets or to spot market reversals.

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IG Analyst

2018-02-09T15:35:26+0000

Source: Bloomberg

Moving averages are often the first stop for novice traders when they first start learning technical analysis. However, they are also used as the basis for trading strategies by more advanced traders.

The simple moving average (SMA) will take the average reading over the prescribed number of candles on a price chart. The lower the number of candles, the more closely the average follows the price, meaning that the average will be engaged by the price more often. Conversely, a higher value moving average will provide a slow moving, less responsive line that will typically be less relevant to near-term price action.

It is worth noting that there are other forms of moving averages that are utilised in place of the traditional SMA. Exponential, smoothed and weighted averages are examples of other types of moving averages that traders will use.

The use of multiple moving averages will typically enable a more powerful trading strategy. The three examples below are examples of moving average trading strategies that utilise multiple averages.

Trend trading with multiple averages

A market that is highly trending will typically show an element of order in relation to moving averages. The chart below highlights that for an upwardly trending market, we should see the price trade below the short-term SMA, with the medium and then long-term averages above that. This would be inverted for a downtrend.

When a market displays this form of orderly characteristic, it allows for a trending market following trading strategy. Buying (uptrend) or selling (downtrend) at the nearest moving average would then allow for traders to find entry points within this highly trending market.

The EUR/GBP chart below highlights this technique, with the price turning back onto the bearish trend from the lower (20) SMA on a number of occasions. The push through the highest moving average (200) provided a signal that this trend is over.

Golden/death cross

The moving average crossover method is one of the most commonly used trading strategies, with a shorter-term SMA breaking through a longer-term SMA to form a buy or sell signal. The death cross and golden cross provide one such strategy, with the 50-day and 200-day moving averages in play. The bearish form comes when the 50-day SMA crosses below the 200-day SMA, providing a sell signal. Conversely, a bullish signal comes where the 50-day SMA breaks above the 200-day SMA.

Mean reversion using Bollinger bands

This strategy utilises the Bollinger band tool with the 20-day SMA placed within the middle of the bands. This technique can be used without the Bollinger bands, but using the bands provides some additional benefits. The idea behind this method is that even when we see a highly trending market, the price will often return to mean before pushing back in the direction of the trend. As such, the middle Bollinger band (the 20-day SMA) will often be utilised as support or resistance, providing a useful buying and selling tool.

The chart below highlights the strategy in action, with the price falling below the 20-day SMA on the top left, indicating the switch from bullish to bearish sentiment. From there on in, the reversion back into the 20-day SMA provided a host of profitable selling opportunities.

On this occasion, the upper Bollinger band would have been useful as a tool to place your stop loss above. Alternatively, utilising the prior swing high would have also provided a profitable trading strategy. The dotted horizontal lines signal where those swing highs are located.

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